It Looks Like The 'Great Rotation' Was Just A Great Big Misunderstanding

January was a historic month for flows into equity mutual funds – at $56.8 billion – and many are still trying to make sense of what exactly happened.

Many have argued that this was reflective of a "Great Rotation" of funds from bonds to stocks.

The problem with that narrative, though, was that bond funds didn't experience outflows in January. Investors were still pouring money into those, too.

The latest weekly H.8 data on bank balance sheets put out by the Federal Reserve offers a clue as to where all of this money is coming from.

The chart below shows deposits at commercial banks in the United States. Banks recorded big deposit inflows in November and December, and in January, those flows reversed and the overall level of deposits shrank at a similar pace:

Bloomberg, Business Insider

When asked about the "Great Rotation" in an interview with Bloomberg TV on Friday, PIMCO CEO Mohamed El-Erian suggested that the expiration of unlimited FDIC insurance on bank accounts with deposit balances over $250,000 could be driving the flows into equities. He said, "What I think we are all seeing – the equity funds, the fixed income funds, the commodity funds – is a rotation out of money market funds and out of bank accounts that no longer have complete FDIC insurance."

That theory would make sense, given the big deposit outflows ($255 billion) we've seen from U.S. banks in January. However, it doesn't sufficiently address the rapid expansion in deposits ($316 billion) observed in November and December.

Furthermore, equity funds don't exactly make a great substitute for the safety of a savings account, FDIC-insured or not.

What Really Happened

The more likely explanation for the deposit outflows, and in turn, a significant portion of the record flows into equities in January, is the mad rush of special dividends paid out by big companies to shareholders ahead of the fiscal cliff at the end of last year.

Some thinkers like John Carney brought up this explanation in recent days.

Bush-era tax cuts that brought the tax rate on dividends down to 15 percent were set to expire, and dividends would, starting in 2013, be taxed as ordinary income – which meant for wealthy investors, the rate would nearly triple. However, the final compromise on the dividend tax at the beginning of January was much better than investors had feared. Nevertheless, those special dividends were already paid out.

Citi analyst Andrew Hollenhorst attributes the surge in deposits in November and December to the special dividends.

The charts below show the spike in dividend payments and the corresponding deposit inflows (click to enlarge):

Citi Research, BEA, SAAR, Fed H.8

Hollenhorst says the expiration of the FDIC insurance cited by El-Erian (known as Transaction Account Guarantee, or TAG) is likely a red herring. In a note to clients, he writes (emphasis added):

Collateral levels, while no longer at their highs, are still at levels that were consistent with Treasury repo of about 19bp in 2012. Many pointed to money market fund (MMF) inflows as a sure sign of TAG deposits shifting.

However, the flows were not focused on institutional government funds, where we would have expected them, and we have begun to see money fund assets decline. As discussed below, we are also unconvinced that bank deposit flows are indicative of TAG reallocation.

Rather than TAG or Operation Twist, we think that the surge in cash entering short-term markets may be partially accounted for by a one time $35.5 billion increase in personal dividend income in Q4 2012. With the fiscal cliff fast approaching, corporations sought to pay special dividends ahead of potential tax rises.

It makes sense that investors, both individuals and institutions, would have in the short term moved some of this windfall into bank deposits and MMFs while waiting to reinvest.

This is consistent with the uptick in late 2012 and downtick in early 2013 in MMF and bank deposits. Interestingly large bank deposits rose about 1% more from Oct.-Dec. in 2012 relative to 2011 and then dropped by a similar amount more in the first three weeks in January.

In other words, there is a compelling argument to be made that the big flows into equity funds in January were driven by the one-off special dividend payments made in late 2012.

If that is the case, the key evidence of a "Great Rotation" into equities at this stage has disappeared.